Warning signs are emerging that South African bonds are vulnerable to an “outsized” selloff amid a drop in market liquidity and low volatility, according to Standard Bank Group.

Average monthly turnover for South African bonds slid 25% in the first half to R452.8-billion, the latest data from the Johannesburg Stock Exchange show. Emerging-market currency price swings increased for five out of the past six days, after falling to a record on July 23, according to a JPMorgan Chase & Company volatility index.

Falling liquidity raises the risk that it will be more difficult to sell the bonds in the event of any deterioration in sentiment, said Asher Lipson at Standard Bank, the nation’s biggest debt arranger.
Rising US interest rates or a slowdown in China, South Africa’s biggest trading partner, could shake investors out of their complacency, he said. Developing markets slid last week as new sanctions were imposed on Russia and after Argentina missed a debt payment.

“Whenever you have bursts of volatility, like we’ve seen, it’s a reminder that things can change pretty quickly,” Lipson, head of fixed-income strategy at Standard Bank, said by phone from Johannesburg on August 1. “With liquidity at these low levels, if investors decide to rush for the door, they’ll find out how small the door is.”

Bonds outflowsSouth African rand bonds, which dropped for the past two weeks, have been underperforming emerging-market peers in 2014. The securities earned 2.1% this year through August 1, compared with a 5.4% average return for 31 sovereign markets tracked by Bloomberg indexes.

Foreign investors were net sellers of the nation’s debt for 10 straight days through July 31, stock exchange data show. That pared inflows this year to R11.3-billion, compared with R26-billion in the comparable period in 2013.

Yields on benchmark government bonds due December 2026 have climbed 22 basis points since July 17, when Reserve Bank Governor Gill Marcus lifted the central bank’s policy rate by 25 basis points and warned of more increases. Policy makers are struggling to tame inflation while limiting the damage higher borrowing costs risk inflicting on the economy.

Yields on the 2026 bonds dropped four basis points to 8.31% by 9.26am in Johannesburg. The rand declined 0.1% to 10.6880 per dollar.

Investor complacencyWhile low volatility usually reduces investment risk, it may make investors complacent, according to Dean Marks, who helps manage fixed-income investments among $6.5-billion of assets at Abax Investments. The rand’s three-month implied volatility versus the dollar, a gauge of options traders’ expectations of price swings, climbed 50 basis points last week from a 14-year low to 10.55%.

“There was a lot of investor complacency a few weeks ago, but that is very quickly waning,” Marks said by phone from Cape Town on August 1. “We’ve seen volatility picking up, we’re starting to see investors taking action. The low liquidity will definitely contribute to heightened risk.”

Signs of a sustained US recovery have bolstered speculation the Federal Reserve is moving toward raising interest rates, which would reduce the relative returns on high-yielding emerging-market assets. US economic growth outpaced economists’ estimates in the second quarter, data showed last week.

“The problem with low volatility is that everyone gets used to the calmer conditions,” Lipson said. “So when there is a reaction, it ends up being far bigger because of the shock.” – Bloomberg